Euro Debt Crisis Explainedby Tejvan Pettinger on July 10, 2014 in economics

In 2007, EU economies, on the surface, seemed to be doing relatively well – with positive

economic growth and low INFLATION . Public debt was often high, but (apart from Greece)

it appeared to be manageable assuming a positive trend in economic growth.

However, the global credit crunch (see: Credit crunch explained) changed many things.1. BANK  Loses. During the credit crunch, many commercial European BANKS  lost money on their

exposure to bad debts in US (e.g. subprime MORTGAGE  debt bundles)2. Recession. The credit crunch caused a fall in bank lending and INVESTMENT ; this caused a

serious recession (economic downturn). See:cause of recession3. Fall in House Prices. The recession and credit crunch also led to a fall in European house prices

which increased the losses of many European banks.

4. Recession caused a rapid rise in government DEBT . The recession caused a steep deterioration in government finances. When there is negative growth, the government receive less TAX :(less people working = less INCOME TAX ; less people spending = less VAT; less company profits = less corporation tax e.t.c. )(The government also have to spend more on unemployment benefits.)

5. Rise in Debt to GDP ratios. The most useful guide to levels of manageable DEBT  is the DEBT  to GDP ratio. Therefore, a fall in GDP and rise in debt means this will rise

rapidly. For example, between, 2007 and 2011, UK public SECTOR  debt almost doubled from 36% of GDP to 61% of GDP (UK Debt – and that excludes financial sector bailout). Between 2007 and 2010, Irish government debt rose from 27% of GDP to over 90% of GDP (Irish debt) .

Selected EU Debt 2007-2010

Green – DEBT  in 2007 Blue – DEBT  in 2010 Facts on EU debt

EU Bond Yield

 

MARKETS  had assumed Eurozone debt was safe. Investors assumed that with the backing of all Eurozone members there was an implicit guarantee that all Eurozone debt would be safe and had no risk of default. Therefore, investors were willing to hold debt at low INTEREST RATES  even though some countries had quite high debt levels (e.g. Greece, Italy). In a way, this perhaps discouraged countries like Greece from tackling their debt levels, (they were lulled into false sense of security).

Increased Scepticism. However, after the credit crunch, investors became more sceptical and started to question European finances. Looking at Greece, they felt the size of public sector debt was too high given the state of the economy. People started to sell Greek bonds which pushes up INTEREST RATES ) see:relationship between bonds and yields)

No Strategy. Unfortunately, the EU had no effective strategy to deal with this sudden panic over debt levels. It became clear, the German taxpayer wasn’t so keen on underwriting Greek bonds. There was no fiscal union. The EU bailoutnever tackled fundamental problems. Therefore, markets realised that actually Euro debt wasn’t guaranteed. There was a real risk of debt default. This started selling more – leading to higher bond yields.

No Lender of Last Resort. Usually, when investors sell bonds and it becomes difficult to ‘roll over debt’ – the Central BANK  of that country intervenes to buy government bonds. This can reassure markets, prevent liquidity shortages, keep bond rates low and avoid panic. But, the ECB made it very clear to markets it will not do this. (see: failures of ECB) Countries in the eurozone have no lender of last resort. Markets really dislike this as it increases chance of a liquidity crisis becoming an actual default.

o For example, UK debt has risen faster than many Eurozone economies, yet there has been no rise in UK bonds yields. One reasons investors are currently willing to hold UK bonds is that they know the BANK  of England will intervene and buy bonds if necessary.

Uncompetitiveness

Eurozone countries with debt problems are also generally uncompetitive with a higher

inflation rate and higher labour costs. This means there is less demand for their exports,

higher current ACCOUNT  deficit and lower economic growth. (The UK became

uncompetitive, but being outside the Euro, the Pound could depreciate 20% restoring

competitiveness. See more at Two speed Europe

Poor Prospects for GrowthPeople have been selling Greek and Italian bonds for two reasons. Firstly  because of high

structural debt, but also because of very poor prospects for growth. Countries facing debt

crisis have to cut spending and implement austerity BUDGETS . This causes lower growth,

higher unemployment and lower tax revenues. However, they have nothing to stimulate

economic growth.

They can’t devalue to boost competitiveness (they are in the EURO ) They can’t pursue expansionary monetary policy (ECB won’t pursue quantitative easing, and

actually increased INTEREST RATES  in 2011 because of inflation in Germany) They are only left with internal devaluation (trying to restore competitiveness through lower wages,

increased competitiveness and supply side reforms. But, this can take years of high unemployment.

Individual Cases

Ireland’s debt crisis was mainly because the Irish Government had to bailout their own

banks. The BANK  losses were massive and the Irish government needed a bailout to pay

for their own bail-out

Greece. Greece had a very large DEBT  problem even before joining Euro and before the

credit crisis. The credit crisis exacerbated an already significant problem. The Greek

economy was also fundamentally uncompetitive.

Italy’s debt crisis – long term structural problems. Very weak growth prospects. Political

instability

Summary of Main Causes of Debt Crisis1. High structural debt before crisis. Exacerbated by ageing population in many European countries.2. Recession causing sharp rising in BUDGET  deficit.3. Credit crunch causes losses for Commercial BANKS . Investors much more cautious and fearful of

default in all types of debt.4. Southern European economies uncompetitive (higher labour costs) but can’t devalue to restore

competitiveness. This causes lower growth and lower tax REVENUES  in these countries.5. No Lender of last resort (like in UK and US) makes MARKETS  nervous of holding Eurozone debt.6. No effective bailout for a country like Italy.7. Fears of default raise bond yields, but this makes it much more expensive to pay interest on debt. e.g.

cost of servicing Italian debt has risen meaning they will have to raise €650bn ($880bn) over next three years. It become a vicious spiral. Higher debt leads to higher INTEREST RATE  costs making it more difficult to repay.

8. It’s very difficult to leave the Euro

Update 2014

One issue has been helped. Action by the ECB has led to a fall in bond yields. This

willingness to intervene in the bond MARKET  has calmed investors and led to lower bond

yields. However, the economy remains stagnant with low growth.

EU ECONOMIC  growth. EU Stat

Timeline: The unfolding eurozone crisis

The current situation in Greece and beyond is the biggest test the EURO  has ever faced

Continue reading the main story

Eurozone crisis

Bank staff fear for jobs and savings

Is Cyprus's euro membership viable?

Q&A: Cyprus deal

German gamble

The euro, the dream of many a politician in the years following World War II, was ESTABLISHED  in Maastricht by the European Union (EU) in 1992.

To join the CURRENCY , member states had to qualify by meeting the terms of the treaty in terms of budget deficits, inflation, interest rates and other monetary requirements.

Of EU members at the time, the UK, Sweden and Denmark declined to join the CURRENCY .

Since then, there have been many twists and turns for the countries that use the single CURRENCY .

1999

On 1 January, the CURRENCY  officially comes into existence.

2001

Greece joins the EURO .

2002

On 1 January, notes and coins are introduced.

2008

Malta and Cyprus join the euro, following Slovenia the previous year.

In December, EU leaders agree on a 200bn-euro stimulus plan to help boost European growth following the global financial crisis.

2009

Slovakia joins the euro.

Estonia, Denmark, Latvia and Lithuania join the Exchange Rate Mechanism to bring their CURRENCIES  and monetary policy into line with the euro in preparation for joining.

In April, the EU orders France, Spain, the Irish Republic and Greece to reduce their budget deficits - the difference between their spending and TAX  receipts.

In October, amid much anger towards the previous government over corruption and spending, George Papandreou's Socialists win an emphatic snap general election victory in Greece.

In November, concerns about some EU member states' debts start to grow following the Dubai sovereign debt crisis.

In December, Greece admits that its debts have reached 300bn euros -the highest in modern history.

Greece is burdened with debt amounting to 113% of GDP - nearly double the eurozone limit of 60%. Ratings agencies start to downgrade Greek BANK  and government debt.

Mr Papandreou insists that his country is "not about to default on its debts".

2010

In January, an EU report condemns "severe irregularities" in Greek ACCOUNTING  procedures. Greece's budget deficit in 2009 is revised upwards to 12.7%, from 3.7%, and more than four times the maximum allowed by EU rules.

The European Central Bank dismisses speculation that Greece will have to leave the EU.

In February, Greece unveils a series of austerity measures aimed at curbing the deficit.

Concern starts to build about all the heavily indebted countries in Europe - Portugal, Ireland, Greece and Spain.

On 11 February, the EU promises to act over Greek debts and tells Greece to make further spending cuts. The austerity plans spark strikes and riots in the streets.

In March, Mr Papandreou continues to insist that no bailout is needed. The euro continues to fall against the dollar and the pound.

The eurozone and IMF agree a safety net of 22bn euros to help Greece - but no LOANS .

In April, following worsening financial markets and more protests, eurozone countries agree to provide up to 30bn euros in emergency LOANS .

Greek borrowing costs reach yet further record highs. The EU announces that the Greek deficit is even worse than thought after reviewing its accounts - 13.6% of GDP, not 12.7%.

Finally, on 2 May, the eurozone members and the IMF agree a 110bn-euro bailout package to rescue Greece.

The euro continues to fall and other EU member state DEBT  starts to come under scrutiny, starting with the Republic of Ireland.

In November, the EU and IMF agree to a bailout package to the Irish Republic totalling 85bn euros. The Irish Republic soon passes the toughest BUDGET  in the country's history.

Amid growing SPECULATION , the EU denies that Portugal will be next for a bailout.

2011

On 1 January, Estonia joins the euro, taking the number of countries with the single CURRENCY  to 17.

In February, eurozone finance ministers set up a permanent bailout fund, called the European Stability Mechanism, worth about 500bn euros.

In April, Portugal admits it cannot deal with its finances itself and asks the EU for help.

In May, the eurozone and the IMF approve a 78bn-euro bailout for Portugal.

In June, eurozone ministers say Greece must impose new austerity measures before it gets the next tranche of its LOAN , without which the country will probably default on its enormous debts.

Talk abounds that Greece will be forced to become the first country to leave the eurozone.

In July, the Greek parliament votes in favour of a fresh round of drastic austerity measures, the EU approves the latest tranche of the Greek LOAN , worth 12bn euros.

A second bailout for Greece is agreed. The eurozone agrees a comprehensive 109bn-euro ($155bn; £96.3bn) package designed to resolve the Greek crisis and prevent contagion among other European economies.

In August, European Commission President Jose Manuel Barroso warns that the sovereign debt crisis is spreading beyond the periphery of the eurozone.

The yields on government bonds from Spain and Italy rise sharply - and Germany's falls to record lows - as investors demand huge returns to borrow.

On 7 August, the European Central BANK  says it will buy Italian and Spanish government bonds to try to bring down their borrowing costs, as concern grows that the debt crisis may spread to the larger economies of Italy and Spain.

The G7 group of countries also says it is "determined to react in a co-ordinated manner," in an attempt to reassure investors in the wake of massive falls on global STOCK MARKETS .

During September, Spain passes a constititional amendment to add in a "golden rule," keeping future BUDGET  deficits to a strict limit.

Italy passes a 50bn-euro austerity budget to balance the budget by 2013 after weeks of haggling in parliament. There is fierce public opposition to the measures - and several key measures were watered down.

The European Commission predicts that economic growth in the eurozone will come "to a virtual standstill" in the second half of 2011, growing just 0.2% and putting more pressure on countries' budgets.

Greek FINANCE  Minister Evangelos Venizelos says his country has been "blackmailed and humiliated" and a "scapegoat" for the EU's incompetence.

On 19 September, Greece holds "productive and substantive" talks with its international supporters, the European Central BANK , European Commission and IMF.

The following day, Italy has its debt rating cut by Standard & Poor's, to A from A+. Italy says the MOVE  was influenced by "political considerations".

That same day, in its World Economic Outlook, the IMF cuts growth forecasts and warns that countries are entering a 'dangerous new phase'.

The gloomy mood continues on 22 September, with data showing that growth in the eurozone's private sector shrank for the first time in two years.

The sense of urgency is heightened on 23 September, when IMF head Christine Lagarde urges countries to "act now and act together" to keep the path to economic recovery on track.

On the same day, UK Prime Minister David Cameron calls for swift action on the debt crisis.

The next day US Treasury Secretary Timothy Geithner tells Europe to create a "firewall" around its problems to stop the crisis spreading.

A meeting of FINANCE  ministers and central bankers in Washington on 24 September leads to more calls for urgent action, but a lack of concrete proposals sparks further falls in share MARKETS .

After days of intense SPECULATION  that Greece will fail to meet its BUDGET  cut targets, there are signs of a eurozone rescue plan emerging to write down Greek DEBT  and increase the size of the bloc's bailout fund.

But when, on 28 September, European Union head Jose Manuel Barroso warns that the EU "faces its greatest challenge", there is a widespread view that the latest efforts to thrash out a deal have failed.

The sense that events are spinning out of control are underlined by Foreign Secretary William Hague, who calls the euro a "burning building with no exits".

On 4 October, Eurozone finance ministers delay a decision on giving Greece its next instalment of bailout cash, sending European shares down sharply.

Speculation intensifies that European leaders are working on plans to recapitalise the banking system.

On 6 October the Bank of England injects a further £75bn into the UK economy through quantitative easing, while the European Central Bank unveils emergency loans measures to help BANKS .

FINANCIAL MARKETS  are bolstered by news on 8 October that the leaders of Germany and France have reached an accord on measures to help resolve the debt crisis. But without publication of any details, nervousness remains.

Relief in the MARKETS  that the authorities will help the banking sector grows on 10 October, when struggling Franco-Belgian bank Dexia receives a huge bailout.

On 10 October, an EU summit on the debt crisis is delayed by a week so that ministers can finalise plans that would allow Greece its next bailout money and bolster DEBT -laden BANKS .

On 14 October G20 finance ministers meet in Paris to continueefforts to find a solution to the debt crisis in the eurozone.

On 21 October eurozone FINANCE  ministers approve the next, 8bn euro ($11bn; £7bn), tranche of Greek bailout loans, potentially saving the country from default.

On 26 October European leaders reach a "three-pronged" agreementdescribed as vital to solve the region's huge debt crisis.

After marathon talks in Brussels, the leaders say some PRIVATE BANKS  holding Greek debt have accepted a loss of 50%. Banks must also raise more capital to protect them against losses resulting from any future government defaults.

On 9 December, after another round of talks in Brussels going through much of the night, French President Nicolas Sarkozy announces that eurozone countries and others will press ahead with an inter-governmental treaty enshrining new budgetary rules to tackle the crisis.

Attempts to get all 27 EU countries to agree to treaty changes fail due to the objections of the UK and Hungary. The new accord is to be agreed by March 2012, Mr Sarkozy says.

2012

On 13 January, credit rating agency Standard & Poor's downgrades France and eight other eurozone countries, blaming the failure of eurozone leaders to deal with the DEBT  crisis.

Three days later, the agency also downgrades the EU bailout fund, the European Financial Stability Facility.

Also on 13 January, talks between Greece and its private creditors over a debt write-off deal stall. The deal is necessary if Greece is to receive the bailout funds it needs to repay billions of euros of debt in March. The talks resume on 18 January.

The "fiscal pact" agreed by the EU in December is signed at the end of January. The UK abstains, as does the Czech Republic, but the other 25 members sign up to new rules that make it harder to break BUDGET deficits.

Weeks of negotiations ensue between Greece, private lenders and the "troika" of the European COMMISSION , the European Central BANK and the IMF, as Greece tries to get a debt write-off and make even more spending cuts to get its second bailout.

On 10 February, Greece's coalition government finally agrees to pass the demands made of it by international lenders. This leads to a new round of protests.

But the eurozone effectively casts doubt on the Greeks' figures, sayingAthens must find a further 325m euros in budget cuts   to get the aid.

On 12 February,  Greece passes the unpopular austerity bill  in parliament - two months before a general election.

Coalition parties expelled more than 40 deputies for failing to back the bill.

On February 22, a Markit survey reports that the eurozone service sector has shrunk unexpectedly, raising fears of a recession.

The next day the European Commission predicts that the  eurozone economy will contract by 0.3% in 2012.

March begins with the news that the eurozone jobless rate has hit a new high.

However, the ECONOMIC  news takes a turn for the better just days later with official figures showing that the eurozone's retail sales increased   unexpectedly in January by 0.3%, and the OECD reports its view that the region is showing tentative signs of recovery.

On 13 March, the eurozone finally backs a second Greek bailout of 130bn euros. IMF backing was also required and was later given.

The month ends with a call from the OECD for the eurozone rescue fund to be doubled to 1tn euros. The German chancellor, Angela Merkel says she would favour only a temporary boost to its firepower.

On 12 April, Italian borrowing costs increase in a sign of fresh concerns among investors about the country's ability to reduce its high levels of DEBT .

In an auction of three-year bonds, Italy pays an INTEREST RATE  of 3.89%, up from 2.76% in a sale of similar bonds the previous month.

Attention shifted to Spain the next day, with shares hit by worries over the country's economy   and the Spanish government's 10-year cost of borrowing rose back towards 6% - a sign of fear over the country's creditworthiness.

On 18 April, the Italian government cut its growth forecast for the economy in 2012. It was previously predicting that the economy would shrink by 0.4%, but is now forecasting a 1.2% CONTRACTION .

On 19 April, there was some relief for Spain after it saw strong demand at an auction of its debt, even though some borrowing costs rose.

The 10-year bonds were sold at a YIELD  of 5.743%, up from 5.403% when the bonds were last sold in February.

On 6 May, a majority of Greeks vote in a general election for parties that reject the country's bailout agreement   with the EU and International Monetary Fund.

On 16 May, Greece announces new elections for 17 June after attempts to form a coalition government fail.

On 25 May, Spain's fourth largest BANK , Bankia, says it has asked the government for a bailout worth 19bn euros ($24bn; £15bn).

On 9 June, after emergency talks Spain's Economy Minister Luis de Guindos says that the country will shortly make a formal request   for up to 100bn euros ($125bn; £80bn) in LOANS  from eurozone funds to try to help shore up its banks.

On 12 June, optimism over the BANK  bailout evaporates as Spain's borrowing costs rise to the highest rate since the launch of the euro in 1999.

On 15 June, former UK chancellor of the exchequer Gordon Brown underlined fears of contagion with a warning that France and Italy may need a bailbout.g

On 17 June, Greeks went to the polls, with the pro-austerity party New Democracy getting most votes., allaying fears the country was about to leave the eurozone